After the collapse of Lehman Brothers Holdings Inc. the three largest credit rating companies were accused of contributing to the subprime mortgage crisis. Distressed securities backed products would not have been able to enter the market and sell without proof of investment grade on their part. In reality, investors have relied on their ratings, often acting at random.
A decade later, a similar drama unfolds around the state-owned China Huarong Asset Management Co. She was unable to publish financial indicators for 2020 in time, and information about a deep restructuring was leaked to the media. After that, the distressed asset management company itself became a distressed asset. Its 4.5% perpetual bond trades at 70 cents, which is not in line with its ratings. Huarong has outstanding bonds of $ 22 billion and issues them every month.
All three rating companies finally woke up. S&P Global Ratings and Moody’s Investors Service put Huarong on the waiting list for a negative outlook credit rating review earlier this month. Fitch Ratings went even further, downgrading Huarong’s rating by three notches on Monday, from A to BBB. China’s China Cheng Xin International Credit Rating Co., which maintains its AAA rating on Huarong’s yuan bonds, also issued a negative outlook on its credit rating on April 14 amid a larger sell-off outside of China.
But they were a little late. Thanks to this mechanical approval of the ratings, Huarong has become one of the largest Chinese issuers despite unfavorable conditions. In the event of a default, foreigners will have to work hard to get the money back. These bonds are not guaranteed by a parent company headquartered in Beijing, but by an offshore subsidiary in financial distress. At the same time, dollar-denominated bonds of other investment-grade SOEs, such as Yunnan Energy Investment Overseas Finance Co., also fell, suggesting investors are losing confidence in the ratings. Why are Moody’s, S&P and Fitch so wrong about Huarong?
In the case of a state-owned enterprise, credit analysts take into account not only its independent financial stability, but also the likelihood of economic support from the government. In some cases, the relationship between them can be so close that, according to a methodological report published by Moody’s last year, independent credit analysis is “either inappropriate or misleading.”
As of June last year, Huarong was 57% owned by the Ministry of Finance. The company, founded in 1999, helped banks get rid of distressed assets. Considering the amount of overdue loans in the system is 2.7 trillion yuan ($ 416 billion), then, according to Moody’s, the asset management company will enjoy a “very high level” of government support. Therefore, despite the fact that Huarong as an independent organization only received a B1 junk rating, the final scores were seven notches higher at the A3 level.
Due to the use of a scoring system and analysis of the likelihood of joint default, such a rating system may seem strange. And in China, its application is not very effective, since the country’s main economic priorities can change faster than foreigners realize it. Once upon a time, strategic directions can lose their importance overnight. After doing all the hard work for the government, SOEs may lose support over time. Often, rating companies are too slow to recognize a shift in political sentiment.
For example, China’s latest plans to tackle global warming, as evidenced by President Xi Jinping’s pledge to achieve zero carbon emissions by 2060, has led to the closure of many coal mines. Unsurprisingly, there has been a spike in defaults by state-owned coal mining companies. On March 9, when Chongqing Energy Investment Group Co., Chongqing’s largest coal operator owned by the municipal government, defaulted on its domestic letter of credit payments, Fitch still maintained its investment rating at BBB. But the agency should have seen an ominous omen. In January, the Chongqing government issued a decree ordering the closure of outdated coal plants, which directly hit the state-owned enterprise’s financial performance.
It also raises the question whether credit analysts considered the possibility that Huarong could also become politically unusable and require replacement. In December, Beijing added a fifth distressed debt management company, China Galaxy Asset Management Co. – to the ranks of Huarong. Galaxy will be the first national distressed debt management company created in the past twenty years. In January, the former head of Huarong, Lai Xiaoming, was sentenced to death – a brutal punishment for financial crime. He was executed just a few weeks later.
At the same time, changes are taking place in macroeconomics. Amid a strong economic recovery, China is resurrecting a corporate leverage campaign launched in late 2017, which was thwarted by Donald Trump’s trade war and then the Covid-19 outbreak. For example, on April 13, the State Council, the highest political body that governs Huarong’s main owner, the Ministry of Finance, issued a tough statement on municipal budgets. It prohibits an increase in hidden debt and requires the restructuring of insolvent financial mechanisms. Similar comments were issued in 2018.
As of June 2020, according to the latest available financial data, Huarong’s assets reached 1.7 trillion yuan and its net worth was only 168 billion yuan. A 10% write-off of assets by a company that got out of control with all kinds of non-core investments such as shadow banking would wipe out its equity. As a result, any delay in implementing the recapitalization plan could result in significant losses for dollar bondholders.
It is, of course, easy to draw conclusions in hindsight. But just as the reassessment of government support begins, SOEs, whose poor financial performance has been neglected because of their perceived strategic importance, are suddenly forced to look at themselves from a commercial perspective. And in this light, they look much less attractive.
And while the situation around Huarong continues to worsen, and credit funds specializing in investments are suffering losses, investors will definitely ask the rating companies: why did you not warn us in advance?